RDP 2011-05: Terms of Trade Shocks: What are They and What Do They Do? 1. Introduction

One of the most significant influences on the Australian economy over the past decade has been the booming terms of trade which has risen by almost 80 per cent. The terms of trade are currently around their highest level of the 140-year history of the series. The current boom is comparable in magnitude to the wool booms of the 1920s and the 1950s but has been sustained for much longer. It more than reverses the trend decline in the terms of trade observed over the second half of the 20th century (see Figure 1).

As discussed by Battellino (2010), previous terms of trade booms have been associated with significant economic volatility, creating complex challenges for economic policy. The booms of the 1920s and 1950s, although initially expansionary, were followed by falling output and rising unemployment. With a fixed exchange rate in place during the 1950s, the concurrent rise in export receipts and capital inflows caused a surge in money and credit, resulting in year-ended CPI inflation of almost 20 per cent. In the period since the float of the Australian dollar the exchange rate response to a change in the terms of trade has become central to the macroeconomic outcome. Gruen and Shuetrim (1994) found evidence that, in the period after the float of the Australian dollar, rises in the terms of trade have tended to reduce domestic inflation in the short run.

We argue that the consequences of a rising terms of trade will ultimately depend on the characteristics of the underlying shock, as well as the policy response. In related work, Kilian (2009) and Peersman and Van Robays (2009) demonstrate that the responses of the US and euro area economies to oil price shocks also depend on the nature of the shock. The recent Australian empirical literature, however, largely ignores this idea.

We identify the impact of global shocks on the terms of trade by estimating a sign-restricted vector autoregression (VAR). Three stylised terms of trade shocks are identified: a world demand shock, a commodity-market specific shock, and a globalisation shock. A positive world demand shock is associated with a pick-up in global economic activity and an increase in export and import prices. A positive commodity-market specific shock increases export prices without a corresponding pick-up in global economic activity.

Finally, a globalisation shock captures the increasing integration of emerging economies, notably China and India, into the world economy. Increased globalisation has been associated with a fall in the relative price of manufactured goods. As Australian imports are concentrated in manufactured goods this is also likely to increase the terms of trade. At the same time, as more countries integrate in to the world economy, the demand for raw materials increases, exerting upward pressure on (commodity) export prices. Such a shock is also associated with an expansion in world output.

We find that positive terms of trade shocks tend to be expansionary but are not always inflationary. Whether these shocks are inflationary depends on both the source of the shock and the response of monetary policy. We also find that the floating exchange rate provides an important buffer against foreign shocks that move the terms of trade: the bulk of variation in the real exchange rate is attributed to world shocks, but the world shocks have very little impact on other Australian variables.

The remainder of the paper is structured as follows. In Section 2 we outline our benchmark VAR and discuss identification of the shocks that move the terms of trade. In Section 3 we estimate the effects of these shocks on Australian inflation, output, short-term nominal interest rates, and the real exchange rate. We also obtain the historical contribution of each identified shock to fluctuations in the domestic variables. The concluding remarks are in Section 4.